The Current, delivered daily.
This post originally appeared on the blog of Bainbridge Growth. It is being republished by The Current with permission.
In recent weeks, many financial headlines have blared warnings on growing inventory levels across the major US retailers. Since Target and Walmart reported earnings in mid May, sentiment on the sector and the broader economy has become notably concerned about shifting buying patterns and demand from lower-earning households. Management teams at these companies have attributed the growing inventories to their intent to increase SKU availability in reaction to broad shortages seen earlier in the pandemic. Increased freight costs also are represented within the inventory dollar amount carried on the balance sheet, a result of higher ocean-borne shipping rates and higher use of air freight.
Inventory-to-sales ratios. (Source: Wall Street Journal)
Some retailers like Target noted that inventory at the end of Q1 2022 skewed towards quarantine-friendly categories that are no longer seeing strong performance. Target CEO Brian Cornell made the decision to deeply discount home goods, appliances, televisions and casual clothing. This move lowered Target’s full year gross margin, sending operating profit margins down from about 10% to the mid single digits. At their recent annual investor presentation, Walmart US leader John Furner called out that 20% of the inventory they’re now carrying are items they “wish they did not have.” Both Target and Walmart management called out Q2 and Q3 as the timeframe where excess inventory would be discounted.
While DTC companies may have less of a concern about cluttering up physical store spaces with out of season items, it is key to observe what product categories are seeing strength so that adjustments can be made. We dug into the several companies in the Bainbridge DTC index, looking into key product categories at companies that also have at least 3 to 5 years of data. We have focused on inventory as a share of sales and gross margin trends for these brands, and gathered extra detail from the most recent earnings reports to determine the primary drivers.
Note: Graphs Displays Ending Q1 Points in Time Only. (Chart by Bainbridge Growth)
The furniture and home goods category is clearly building inventory with Bainbridge DTC index members Lovesac and Purple Innovation showing increases in inventory as a % of sales when compared to pre-pandemic. Lovesac management touted their differentiated product and word of mouth reliant marketing model, and mentioned that their mid and high-end offerings continue to perform well. The company reiterated its guidance even as there was a clear slowdown in their entry level portfolio that caters to lower income customers. Lovesac CEO Shawn Nelson referred to their growing inventory as non-seasonal with a small number of SKUs that sell year round, positioning them well to support a growing customer base. Their margins have been stable, with no intent to increase discounting to meet guidance and no resistance to price increases.
The slowness in home goods is especially impactful to commoditized products like mattresses. Purple Innovation’s inventory jumped to 18% of Q1 2022 annualized sales, more than double any Q1 in the last 5 years. The company struggled in Q1 2022 as sales declined 23% YoY compared against a stimulus-aided Q1 2021. Management reduced full year 2022 sales guidance by 18%, cut headcount, and reduced cost per click advertising. Softness came from deterioration in ecommerce sales (-36% YoY) as Q1 progressed reflecting a “general rationalization” of a quarantine friendly category combined with a shift to in store buying. Management also called out customer resistance to price increases in the quarter. Company gross margin declined in Q1 primarily driven by a large shift toward wholesale and away from eCommerce (67% of mix down to 60%).
Another category that has been challenged is casual wear which many people gravitated towards during the pandemic. This includes athleisure wear, hoodies, jogging pants, and comfort footwear. Lululemon has one of the most pronounced YoY increases in inventory throughout the Bainbridge Index, with inventory jumping 74% YoY while sales grew at a rate of 32%. Lululemon’s CFO mentioned they are focused more on matching their 3YR compounded annual growth rate of sales vs inventory. Q1 20 is elevated for many companies as the March 2020 period was notably weak for discretionary consumer demand. Lululemon has seen one of the most impressive sustained growth stories in 2022, as the company “saw no lift from Q1 2021 stimulus” so sales growth is actually accelerating in 2022. Supporting this growth in store and online will require higher inventory levels (guidance is inventory YoY growth peaks in Q2, and will drop in H2 2022).
Note: Graphs Displays Ending Q1 Points in Time Only (Graph by Bainbridge Growth)
Oxford Industries’ Tommy Bahama brand saw extremely strong performance in Q1 2022, demonstrating another sign that branded casual apparel is still performing well. The brand grew 46% YoY, versus the total company rate of 33% (Tommy Bahama is 64% of total Oxford sales). The brand’s very prominent orientation towards vacation and linen wares has boosted its sales in the women's segment, as demand shifts from casual leggings to higher priced occasion dresses. All channels remained in growth mode as ecommerce grew 20% (25% of sales) against retail store sales of 49% (39% of sales). Oxford raised its full year EPS guidance by 11% on improvements in sales and gross margin and has increased their inventory to a five-year high to support their rapidly improving outlook.
While broad consumer demand remains strong, it is safe to conclude that the lower end of the income spectrum is seeing pressure from rising gas and food prices. Target and Walmart cater to that income segment and obviously have an immense range of products, therefore carrying more risk of abrupt changes in customer buying patterns. As they discount these products, it remains to be seen in Q2 and Q3 how this will affect margins of online DTC players. DTC brands that are least exposed to these inventory buildup trends are those with relatively narrow and differentiated product portfolios, loyal ecommerce customers, and a mix toward upper middle income earners that are not stimulus reliant.
Trending in Operations
The job market continues to hum.
The labor market continued to show strength to start 2023, as the monthly jobs report posted big numbers.
Key data from the U.S. Bureau of Labor Statistics’ monthly jobs report:
- Unemployment fell to 3.4%, ticking down from 3.5% in December to remain at historic lows.
- The economy added jobs to the tune of 517,000, which bested the 2022 average of 401,000.
- Average hourly wages rose by $0.10, marking year-over-year growth of 4.4%.
The Current’s view: The labor market continues to be an economic outlier. While there are signs of consumer pullback and belt-tightening among tech companies and retailers after months of high inflation, the job picture remains bright. While tech companies and some retailers are cutting back markedly, there are few signs of the widespread “pain” that economists predicted in this indicator of the economy.
What brands and retailers are thinking: Jobs are a major indicator of demand, and the labor market continues to hum along. That means the consumer pullback is tied to choices about discretionary spending and holding off on certain purchases in the face of high prices, moreso than being unable to afford items altogether.
What the Fed is thinking: Here’s more evidence that a soft landing might be possible. The Fed has been raising interest rates to bring down inflation. There is risk that this will slow down the economy, including employment. There was some slowing in job growth in December, but this report indicates labor market softening still hasn’t happened for a sustained period, even as inflation is cooling. After the central bank scaled back its latest interest rate hike to 0.25% on Wednesday, Fed Chair Jerome Powell said he sees a “path” to bringing down inflation without a significant rise in unemployment. Here’s one more piece of data to bolster that belief.
Keep in mind: The labor market is still out of balance between supply and demand. This report shows a big rise in jobs and the labor force participation rate remaining the same. Job openings actually increased in December, the Labor Department found. So there a still the case. Eventually, it will likely have to come into balance. But given the unpredictability of this economic era, it’s tough to know when, or even how.